This blog aims to study the mechanics of business and occasionally find a gem of insight.

(Consult your financial adviser before making investment decisions. Following the advice here does not guarantee performance and there is a substantial risk of loss)

Monday, April 19, 2010

George Soros - Breaking the Bank

We were discussing the notorious story of George Soros' shorting of the UK pound in our GMP class this morning.

The story begins with the UK joining Europe's Exchange Rate Mechanism (ERM), not exactly fixed but had a policy where the currencies were staying within an exchange rate band. This simultaneously existed with a carry trade scenario where the German government was offering a higher interest rate than the British Government so people were borrowing in pounds and lending in DMs.

George Soros foresaw the opportunity where people who were participating in carry trades with the British pound created an opportunity for currency deprectiation. He sold off all his positions and then proceeded to short the position. This aggressive "attack" position resulted in many other fund managers dumping pound denominated assets. On the "Black Wednesday", the Bank of England tried to fight back by raising interest rates up to as high as 15% that day, but it wasn't enough.

Also, this is compounded by the required draw of the UK's foreign reserves (another avenue to defend against currency depretiation) to prop up the currency would have resulted in a significant depletion which would not have benefited nor saved the currency (essentially paying out the speculators).

This reminds me of the scenario I experienced in the finance trading lab where I could see the ask list depleting very quickly (low number of orders). The Interest Rate Parity condition only holds if you have a player who is large enough to hold the position of the currency. In a scenario (often repeated in other markets) where people put a currency (or any financial instrument) under siege, it makes it difficult for players to hold their positions as they take massive losses.

Eventually, as the story concludes, the epilogue is that the UK bank decided to let go and allow the currency to depreciate. George Soros also made a reported $1B USD.